RBA may not cut rates as much as the market expected

With financial markets once again in turmoil, investors are understandably looking for a circuit breaker and wondering if central banks will once again come to the rescue. While many central banks don’t have much standard monetary policy ammunition to fire at the latest flare-up, the Reserve Bank of Australia is in the fortunate position of having ample ammunition up its sleeve. And the markets are confident that the RBA is about to use this firepower, and at one stage had priced in more than 180bps of easing over the next year. The question is what the RBA will make of all this. In our view, the nature of the current financial market volatility means that an emergency rate cut is very unlikely, and neither is a very aggressive rate cutting cycle in the next few months. But the RBA is likely to cut its growth forecasts, and so there is a small chance that the RBA may now concede that tight monetary policy is no longer required.

The “standard” share market rout

When looking at the financial market carnage unleashed by the downgrade of the US by S&P, the central bank of a small country like Australia will ask itself what is the nature of the crisis (of course the difference between the central bank of a large economy and a small one is that the policy of the Fed can change the direction of global markets whereas the RBA has to take that as given). If it is a “standard” share market rout — such as the tech wreck in 2001 — then the response for the central bank is quite straightforward. While a central bank won’t be concerned about the lower share prices per se, if the loss of household wealth undermines consumer and business confidence, and so presages a period of much weaker growth, then the central bank should cut rates. Similarly, if the collapsing share market reflects a major reassessment of the future profitability of companies (and so their willingness to invest and employ people) then this is relevant new information for the central bank and easier policy should be on the agenda.

Now, it is true that the larger the plunge in share markets, the greater the risk that confidence will be undermined and the more likely it is that central banks will have to respond to the changed circumstances. But in this “standard” share market fall scenario, the process of setting interest rates is no different than usual. That is, the lack of confidence will be reflected in surveys of business and consumer confidence. Retail spending will be softer and employment will start declining. And firms will start trimming investment plans.

In other words, the share market plunge will give the central bank an early warning of what might be about to come through, but the share market plunge itself is simply another one of those factors — along with fluctuating FX rates, commodity prices, inclement weather, government policy — that goes into determining the how fast or weak the economy is. And to be sure, the sensitivity of the central bank to the share market plunge will depend on how strong the economy is when that occurs. Thus, if unemployment is near 10%, then it would make sense for the central bank to react more to downside risks, than if the unemployment rate was 5%.

The “exceptional” share market rout

The second type of financial crisis is where markets themselves become dysfunctional. This was obviously the case in the global financial crisis, when funding markets for the financial system simply dried up. The point here is that the standard monetary policy procedure no longer operates. If a central bank waits to see data showing that retail sales have fallen, then it will be far too late to support the economy. In this situation, central banks have to be very pre-emptive.

With that background, how will the RBA view the current situation? Well, the starting point might well be that the current volatility is more akin to the “standard” share market plunge. Nothing new was revealed by the S&P downgrade. The banks are in a much sounder funding position than they were in 2008 — more capital, more stable sources of funding, better liquidity etc. Exchange settlement balances at the RBA have averaged around $1.1bn in recent days, compared to $6.5bn in mid 2008 and over $16bn at the peak of the GFC. And the RBA said on 9 August that while it is monitoring markets carefully, it has seen no strains in domestic money markets and that its daily operations were proceeding as normal. That is a big difference to 2008.

In this scenario, the plunge in equity values will dent confidence and so will lead to growth downgrades. But it is a judgement call as to whether the Australian growth outlook has deteriorated to such an extent that interest rates cuts need to be made, especially when taking into account other factors such as the much weaker exchange rate. (By the way, Macquarie thinks growth will be much weaker than forecast by the RBA, so we clearly think there is scope to cut rates. The question, however, is whether the RBA’s growth outlook has changed sufficiently). The second question is if the RBA thinks it is worthwhile undertaking a precautionary rate cut (a “just in case” cut). That is, whether it would be a one-off rate cut, as occurred in 1998, or the start of a string of rate cuts, as occurred in 2008.

But while the starting assumption might have been that this was just another “standard” share market collapse, there have been some recent developments which suggest that it could evolve into something more sinister. The VIX has soared, bank CDS have widened substantially and the intra-day moves in equity, FX, credit and interest rate markets are huge. And with such volatile markets, there is a greater risk that some financial institution sustains large trading losses, which heightens risk aversion and reinforces this negative momentum. None of these developments imply that the financial sector is as vulnerable as it was in 2008. But clearly there is a risk that things could continue to deteriorate. And if they did, then the RBA would have to respond.

What will the RBA do?

All that said, what will the RBA do? First, we think the chances of an intermeeting rate cut by the RBA are very low. Even in 2008 when markets were completely dysfunctional, the RBA didn’t change policy outside of its usual meeting timetable. With the acute pressures in the global banking system that were present then, not apparent now, we see no reason to think that the RBA will move policy outside of its scheduled meetings. The one potential exception to this is if the RBA participated in a co-ordinated policy easing by global central banks. But the problem here is that the banks that would lead that monetary policy easing — the Fed, the Bank of England, the Bank of Japan — haven’t got any scope to cut rates. And given that, we don’t think a fall in Australian interest rates would do much to calm global financial markets.

So if the RBA does cut rates, it is most likely to come at a regular policy meeting. But how soon and how far would rates fall? The biggest risk to the RBA’s growth forecast is the outlook for mining investment. As the RBA said in its recent Statement on Monetary Policy, around 2/3 of growth is expected to be driven by mining investment. So from the RBA’s perspective, the key risk is that weaker global growth undermines Chinese activity and commodity prices, and this results in resources companies revising down their investment plans. While global growth expectations will fall noticeably — a decline from 4¼% to 3½% seems distinctly possible — it is less clear how China will fare and whether the demand for commodities will be much affected. At the same time, the RBA has been optimistic that the nature of the investment projects — very large projects with long-term price contracts and scheduled deliveries — means that investment has to proceed despite the vagaries of global growth.

Even so, the RBA’s confidence in those mining investment forecasts must have weakened. And of course, the RBA will be running the red pen through its forecasts for consumer spending and housing activity. That, in turn, means that the employment outlook must also have weakened. The RBA has tried to depict monetary policy as being marginally restrictionary at present. And so, it could be argued that the changed outlook suggests that monetary policy should be at least neutral. That would point to a modest 25-50bps rate cut, but not the very aggressive easing of policy factored in by markets. In effect, the RBA could describe it as a precautionary rate cut that will be reversed if the global economy stabilises. This would be analogous to the RBNZ’s rate cut after the Christchurch earthquake.

The other important factor for the September Board meeting is that the RBA will have the results of the latest Capex survey. Firms were surveyed in July and August about their expectations for the next year. And so while the survey — which will be released on 1 September — won’t fully capture the impact of the latest financial market volatility there will be some impact. And a sizeable downgrade in investment expectations would provide evidence that easier policy was warranted. It should also be noted that the two previous occasions when financial market volatility triggered RBA interest rate cuts — in 1998 and 2008 — they also followed a substantial downgrade to the investment outlook in the Capex survey.

In summary, the current outbreak of financial market turbulence clearly has implications for RBA policy. The global and domestic growth outlook will need to be downgraded as consumer and business confidence declines. But while the current crisis could evolve into another global financial crisis, the RBA’s comments about the smooth functioning of money markets (at least so far) indicates that we are not in that position now. This suggests that an intermeeting rate cut by the RBA is not likely. And also that very aggressive rate cuts are not likely at this stage. Indeed, in our view, there is still a sizeable hurdle for the RBA to overcome before it would concede that rate cuts are necessary.

For that reason, we think that the chance of an RBA rate cut at the September Board meeting is probably around 25%. Last week, we would have said that a rate cut in September was very unlikely, so that is a big change in a week, but it’s still far from being the central scenario. At one stage, market pricing suggested the RBA would cut rates by 180bps over the next year, which would have taken the standard variable mortgage rate back down to the lows it reached in 2001 and 2009 at around 6%. But unless the RBA starts to think that mining investment is poised to collapse and is seeing unemployment rising rapidly, we don’t think the RBA would be comfortable in turning the monetary policy lever to maximum thrust.

Policy in 2012 is another story. We think that some parts of the retail sector are near the point at which they will start shedding labour. And as the unemployment rate starts rising, this will force the RBA to confront the prospect of pushing rates into expansionary territory. And if the mining boom also disappoints, then the RBA could easily be entering a standard rate cutting cycle next year.

But why is market pricing entertaining the possibility of such an aggressive easing in the short term? One suggestion is that the Australian interest rate market is one of the few in the world where you can bet on a central bank cutting rates aggressively in response to the current financial market volatility. In effect, global traders could be using Australia as a proxy for the global economy. And that has certainly been a profitable strategy for many investors recently. But, ultimately, the RBA retains control of the cash rate. And while investors have to respect the market, the market has to respect the central bank, as they can remain solvent longer than the market can remain irrational.

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